Crunch time

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California's Gov. Gray Davis will tell us this week how he expects to deal
with his state government's projected shortfall, which could reach $35
billion over the next 18 months. That's right, $35 billion-about as much
as the sum of the currently projected shortfalls of the other 49 states
combined.

Yes, the figures may be a bit impressionistic: The projected
shortfall was pegged at just $21 billion back in November when Davis
won re-election. But whatever the number, it's still a huge chunk of an
annual state budget that currently totals $99 billion. How did Davis, an
intelligent man with nearly 30 years of experience in California's state
government, get into such a mess?

The answer,
sadly, is the
same way
almost everyone
else did-only
more so.
California is an
extreme case,
but most state
governments
have similar
problems, and
so does the
federal
government.
Stories about
budget shortfalls
and revenue
shortfalls are a staple right now in papers from Massachusetts to
Arizona. Framing the issue this way-current taxes are not bringing in
enough revenue-suggests an obvious solution: raise taxes. Davis is
likely to ask for higher taxes this week. Republican Govs. Mike
Huckabee of Arkansas and John Rowland of Connecticut already have.

But there's another way to look at the states' fiscal problems. And that
is to look at spending. In good economic times, governments got into
the all-too-easy habit of increasing spending faster than the economy
was growing. State government spending was up 39 percent from 1996
to 2001. In the four years Davis has been governor, California's annual
budget has soared from $74 billion to $99 billion, a 34 percent increase.
For a time, that spending increase was fueled by the Silicon Valley
boom: Capital gains yielded $17 billion to California in fiscal year 2000.
But did California's politicians and budget analysts really think tech
stocks would soar forever? From fiscal year 2000 to 2001, state
spending rose 14 percent even as the high-tech sector plunged
downward. One of the lessons of California's woes is that progressive
taxes, which may be desirable for public-policy reasons, produce
dangerously volatile revenue streams-huge amounts in good years, next
to nothing when the stock market is falling. States that rely on
progressive taxes should be especially careful not to overspend when
revenue comes gushing in.

Fiscal discipline. Not all states overspent in good times. In states like
Colorado, governors and legislatures showed more restraint and built up
larger rainy-day funds for the leaner times. In recent years, the federal
government has not been a model of restraint either, even when
Republicans controlled Congress. Newt Gingrich's first year as speaker
produced a disciplined 1996 budget, but by 2001 annual federal
spending had spiked 19 percent. And the feds have often offloaded
spending onto the states through unfunded mandates and expensive
requirements for Medicaid, whose costs are rising rapidly.

Governors and legislators complain eloquently about the pain of "cutting"
planned spending increases. But the formula governments typically
use-spending must rise by the increase in the population served, plus
inflation-is based on the flawed assumption that government has
achieved maximum efficiency and that any cut will reduce output.
Anyone familiar with the workings of large organizations knows this is
wrong. In good times governors like Davis were able to get by without
nipping and tucking, improving efficiencies and reducing waste. Now it is
crunch time, and they must do the things they should have been doing
all along.

How will the current dilemma affect most citizens? Some will notice
cutbacks in state programs or spending. For most, however, the big
effect will be macroeconomic. In 1996 through 2001, robust increases in
state spending contributed to growth of the domestic product. Now tax
increases threaten to take away consumers' disposable income and
impede economic growth. The states will be retarding recovery.

There aren't a lot of easy choices or answers at the moment. The
scheduled Bush tax cuts have put the federal government in a fiscal
crunch, with congressional appropriators cursing the limits set by Office
of Management and Budget Director Mitch Daniels. Shortfalls in state
revenues have put the state governments in a fiscal crunch. Both have to
deal somehow with sharply rising healthcare costs. As in the war
against terrorism, so as in fiscal policy, we seemingly have moved
suddenly from easy living to crunch time. But when we look back, we
can see now that we should have realized it was crunch time all along.